Central banking in the credit turmoil: An assessment of Federal Reserve practice

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Abstract

Central banking is understood in terms of the fiscal features of monetary, credit, and interest on reserves policies. Monetary policy – expanding reserves by buying Treasuries – transfers all revenue from money creation directly to the fiscal authorities. Credit policy – selling Treasuries to fund loans or acquire non-Treasury securities – is debt-financed fiscal policy. Interest on reserves frees monetary policy to fund credit policy independently of interest rate policy. An ambiguous boundary of responsibilities between the Fed and the fiscal authorities contributed to economic collapse in fall 2008. “Accord” principles are proposed to clarify Fed credit policy powers and secure its independence on monetary and interest rate policy. The Fed needs more surplus capital from the fiscal authorities to be fully flexible against both inflation and deflation at the zero interest bound.

Research Highlights

►Central bank understood in terms of fiscal features of money, credit, and interest on reserves policies. ►Monetary policy, buying treasuries with reserves, transfers all revenue directly to treasury. ►Credit policy is debt-financed fiscal policy. ►Interest on reserves frees monetary policy to fund credit policy independently of interest rate policy. ►Ambiguous boundary of responsibilities between Fed and Congress contributed to panic in fall 2008.

Introduction

The credit market turmoil that began in August 2007 and precipitated the Great Recession challenged central banks around the world as never before. Central banks increased aggregate bank reserves enormously, and lowered targeted short-term interest rates to zero in many countries. For instance, the Federal Reserve grew bank reserve balances from around 10 billion dollars in early September 2008 to over 1 trillion dollars as it drove the federal funds rate nearly to zero.

Central bank lending expanded to facilitate private credit flows. For instance, Federal Reserve loans to depository institutions stood at over 400 billion dollars at the end of April 2009. Previously, the most expansive, prolonged Fed lending was a loan of roughly 5 billion dollars to Continental Illinois Bank from May 1984 until February 1985.1 The Fed extended its credit reach well beyond depository institutions. By April 2009, the Fed had purchased around 350 billion dollars of mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae; and the Fed had extended around 200 billion dollars of loans to a special purpose vehicle created to purchase commercial paper.2

Still farther afield, the Fed extended credit to three limited liability companies in conjunction with efforts to stabilize institutions that it deemed to be critically important. In mid-March 2008 the Fed agreed to extend roughly 29 billion dollars to Maiden Lane I so that it could acquire a variety of mortgage obligations, derivatives, and hedging products to facilitate the acquisition of Bear Stearns by JP Morgan Chase. Maiden Lane II and III were both created to restructure the Fed’s lending to AIG in the aftermath of its financial support for AIG in September 2008. Together, the Fed lent Maiden Lane II and III roughly 50 billion dollars to purchase, respectively, residential mortgage-backed securities from AIG, and multi-sector collateralized debt obligations on which AIG wrote credit default swap contracts.3

All together, the Fed grew its balance sheet from around 900 billion dollars in mid-2007 to over 2 trillion dollars as of April 2009. The Fed did so while reducing its purchases of US Treasury securities from around 800 to 550 billion dollars. The Fed funded its enormous increase in lending with around 250 billion dollars from the sale of Treasury securities, around 300 billion dollars of additional deposits provided by the Treasury, and the creation of around 800 billion dollars of bank reserves for a grand total of around 1.3 trillion dollars of Fed lending as of April 2009. Since then, the Fed mainly shifted the composition of its assets—shrinking its lending to depositories and through various special facilities, rebuilding its holdings of Treasuries to around 800 billion dollars, increasing its holdings of mortgage backed securities to around 1 trillion dollars, and acquiring about 170 billion dollars of federal agency debt securities.4

The Fed and other central banks around the world have undergone a “stress test” that is still very much in progress. Yet enough time has passed to take stock, not so much to evaluate the timing, magnitude, and effectiveness of particular actions, but to observe how central banks put their various powers to work, and to use the observations to rethink central banking more generally.

This essay presents a framework for thinking about central banking in light of these extraordinary developments. The reconsideration begins by classifying core central banking initiatives as monetary policy, credit policy, or interest on reserves policy. Briefly, monetary policy refers to open market operations that expand or contract high-powered money (bank reserves and currency) by buying or selling Treasury securities. Credit policy shifts the composition of central bank assets, holding their total fixed. Interest on reserves policy involves adjusting interest paid on bank reserves.

The three-fold classification did not matter much for the Fed in the past. Until the recent credit turmoil Fed credit policy played a relatively minor role. The Fed could not pay interest on reserves. And monetary policy was utilized to target the federal funds rate. However, the classification is essential to understand the extraordinary central banking initiatives in the current context.

The heart of the paper is the idea that monetary, credit, and interest on reserves initiatives all involve fiscal policy in important but different ways, and that it is essential to understand each initiative in terms of its fiscal features. Fiscal policy involves the use of public funds acquired with current taxes or by borrowing against future taxes. For the purpose of this paper, fiscal policy should be understood to include the lending of public funds to particular borrowers financed by selling Treasury securities against future taxes.

From a fiscal policy perspective, monetary policy saves the government interest that it would pay otherwise on outstanding Treasuries. Mechanically, the interest saving is achieved because the central bank returns to the Treasury after expenses all the interest it receives on the Treasuries it acquires in the conduct of monetary policy. Thus, expansionary monetary policy provides the fiscal authorities with a flow of additional revenue. In particular, all the revenue from monetary policy is transferred via the acquisition of Treasuries to the fiscal authorities to allocate as they see fit.

Credit policy is not monetary policy because it does not alter the stock of bank reserves or currency outstanding. Credit policy involves lending to particular borrowers or acquiring non-Treasury securities with proceeds from the sale of Treasuries. The fiscal authorities then receive interest on the credit assets instead of interest on the Treasuries held by the central bank. In effect, credit policy commits future taxes to back loans or non-Treasury security purchases via the sale of Treasuries. Thus, credit policy involves the fiscal allocation of public funds in a way that monetary policy does not.

Interest on bank reserves is not monetary or credit policy since it involves neither the size nor the composition of the central bank balance sheet. Interest on reserves uses public funds to pay interest on bank reserve balances at the central bank; therefore interest on reserves also involves the allocation of public funds in a way that monetary policy does not.

These and other fiscal features of monetary, credit, and interest on reserves policies are employed below to identify and evaluate the role that each type of initiative plays in central bank stabilization policy.

The paper also considers questions of central bank independence. Flexibility and decisiveness are essential for effective central banking. Independence is essential to enable a central bank to react promptly to macroeconomic or financial shocks without the approval of the Treasury or the legislature. Central bank initiatives must be regarded as legitimate by the fiscal authorities and the public. The problem is to identify the limits of independence on monetary, credit, and interest on reserves policies to preserve a workable, sustainable division of responsibilities between the central bank and the fiscal authorities.

Monetary policy can be conducted independently by a central bank because the objectives of monetary policy – price stability and full employment – are reasonably clear and coherent, and confining purchases to Treasuries transfers all the revenue from money creation directly to the fiscal authorities.

Neither condition is satisfied for central bank credit policy. Objectives that guide and circumscribe central bank credit policy have not been clear, and credit policy inherently involves the fiscal allocation of public funds. Prior to the passage of the Dodd-Frank financial reform legislation of 2010, Alan Greenspan wrote that in 1991

“at the urging of the Federal Reserve Board of Governors, Section 13-3 of the Federal Reserve Act was considered, and amended, by Congress. The section grant[ed] virtually unlimited authority to the Board to lend in “unusual and exigent circumstances””.5

Given the inherent fiscal nature of credit policy, it is not surprising that expansive Fed credit policy in the recent turmoil created conflict with the Congress. In light of that experience, the Dodd-Frank law limits the Fed’s power to lend, requiring Fed lending extended beyond depository institutions to be approved by the Treasury Secretary and to be part of a broad program not directed to any particular borrower.

This paper develops a set of principles as the basis for a Treasury-Fed “accord” to clarify and limit the Fed’s credit policy powers and preserve its independence on monetary and interest on reserves policy. 4.2 Fed lending to facilitate the acquisition of Bear Stearns by JP Morgan Chase, 4.3 Federal Reserve support for AIG below suggest that ambiguity in the responsibility for the provision of fiscal support for the financial system contributed to panic and economic collapse in fall 2008. Among other things, the “Accord” principles are motivated by the realization that an independent central bank cannot be relied upon to deliver or decide upon the delivery of fiscal support for the financial system.

The essay proceeds as follows. Section 2 classifies central banking initiatives into monetary policy, credit policy, and interest on reserves policy. Section 3 explains how monetary, credit, and interest on reserves policies work in terms of their fiscal features. Section 4 assesses five actual Federal Reserve initiatives in the credit turmoil—the Term Auction Facility, Fed lending to facilitate the acquisition of Bear Stearns by JP Morgan Chase, Fed support for AIG, emergency authority to pay interest on reserves, and the joint statement by the Treasury and the Fed on the role of the Fed in preserving financial and monetary stability. Section 5 develops and presents the “accord” principles for clarifying the boundary of central bank credit policy. Section 6 considers monetary and fiscal proposals to strengthen policy flexibility at the zero interest bound and in the exit strategy—use by the central bank of non-monetary managed liabilities, and enlarged surplus capital on the central bank balance sheet. Section 7 is a brief conclusion.

Section snippets

Monetary policy, credit policy, and interest on reserves policy

Monetary policy consists of open market operations that expand or contract high-powered money (bank reserves plus currency) by buying or selling Treasury securities. Until the recent credit turmoil, the Fed satisfied virtually all of its asset acquisition needs in support of monetary policy by purchasing Treasury securities, an acquisition policy known as “Treasuries only”.6 This

Fiscal aspects of monetary, credit, and interest on reserves policies

Monetary policy involves fiscal policy in two ways. First, monetary policy governs the tax rate on bank reserves. The tax rate on reserves is the wedge between the overnight interbank interest rate, i.e., the federal funds rate, and interest paid on reserve balances held overnight at the central bank. Monetary policy varies the scarcity of reserves in the banking system in order to influence the marginal liquidity services yield on reserves. For instance, draining reserves to increase their

Fiscal aspects of five Federal Reserve initiatives

This section describes five Fed initiatives in the credit turmoil: the Term Auction Facility, Fed lending to facilitate the acquisition of Bear Stearns by JP Morgan Chase, Fed support for AIG, emergency authority to pay interest on reserves, and the joint statement by the Treasury and the Fed on the role of the Fed in preserving financial and monetary stability. The descriptions highlight the role that fiscal policy plays in each of these initiatives, and how at times the fiscal aspects of

Clarifying the boundary of central bank credit policy

The 1951 Accord between the Treasury and the Fed was one of the most dramatic events in US financial history. The Accord ended an arrangement dating from World War II in which the Fed agreed to use its monetary policy powers to keep interest rates low to help finance the war effort. The Truman administration urged an extension of the agreement to keep interest rates low in order to hold down the cost of the huge Federal government debt accumulated during the war. Fed officials argued that

Central banking at the zero bound and in the exit strategy

The Fed’s 2 trillion dollar balance sheet and near zero interest rate policy stance appear to have achieved some stability in economic and financial conditions.35 However, the Fed must remain poised to tighten financial conditions on short notice if conditions warrant or to expand its balance sheet further if economic conditions weaken again. To be fully flexible at the zero interest bound the Fed must position itself to raise interest rates promptly against inflation if

Conclusion

The proposed classification of central bank policies into monetary policy, credit policy, and interest on reserves policy could be utilized productively in the Fed’s internal deliberations and in its external communications to (1) improve the transparency of the Fed’s operations for purposes of accountability and credibility, (2) distinguish the fiscal aspects of Fed policies for the purpose of clarifying the boundary of its independent responsibilities, (3) help secure the Fed’s operational

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    Presented at the 75th Anniversary Carnegie Rochester Conference on Public Policy, April 16–17, 2010. The paper benefited from earlier conference presentations at the Bank of Japan, Princeton University, De Nederlandsche Bank, and the Federal Reserve Bank of Atlanta, as well as seminars at the Bank of England, the Board of Governors of the Federal Reserve System, the Federal Reserve Banks of Cleveland, Kansas City, New York, and Richmond, the London School of Economics, and Saint Vincent College. Comments by the conference discussants D. Altig, V.V. Chari, L. Ohanian, F. Smets, and H. Ugai were particularly valuable.

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